24 July 2014
by SAMI KARAM
Using Google as a comp for future growth and valuation.
Facebook’s market cap is now very close to $200 billion. Its projected sales for 2014 are around $12 billion, which means that its stock is trading at over 16x forward sales. To many, this valuation seems justified by Facebook’s very high margins and growth rates.
For the sake of comparison, Google’s market cap reached $200 billion for the first time in 2007. Back then, its revenue growth rate was similar to that of Facebook today (not far from 60%) and its margins were slightly lower. Google stock in that year traded in a range of 8 to 14x sales, significantly lower than Facebook today.
Judging by what happened in subsequent years, you could say that Google’s 2007 peak valuation was justified. Since then, Google’s market cap has doubled to exceed $400 billion today. So if you are a Facebook bull, you can pencil in $400 billion as a target market cap and $150 target stock price.
The main problem with this logic is that things rarely evolve in a linear fashion. In other words, on the road to $400 billion and $150, we may first see $100 billion and $38.
An investor who bought Google stock in late 2007 and who held until today has outperformed the S&P 500 by a wide margin. But all of this outperformance has occurred in the 18 months from July 2012 to December 2013. In 2008, Google stock crashed like everything else, falling by two thirds, and its stock did not regain its 2007 high until late 2012.
Nonetheless, despite the 2008-09 crisis, Google sales continued to grow, albeit at a lower rate. Revenue growth was 56%, 31%, and 9% in 2007, 2008 and 2009. It reaccelerated in the subsequent years 2010-2013, to 24%, 29%, 32% and 19%.
(Tables show 2014 year to date.)
As shown in the table, these are attractive growth rates but a far cry from what they were in the years to 2007. Even if you ignore the 2008-09 collapse, sales growth at Google has been on a long-term downward trend. It is very difficult if not impossible for a large company to maintain 50% growth rates.
Going back to Facebook, there are no doubt multiple justifications to hold the stock: the increased role of mobile, the potential for higher revenues per user, the integration of acquisitions etc. But a long position is betting on both flawless execution and a supportive macro environment.
At current valuations, the stock is priced for perfection not only at the micro level (its own operations) but also on the macro level (the overall economy and market). The odds are we will not see a major crisis like 2008 again soon, but what happens to Facebook stock if the economy slows down? Advertising is a notoriously cyclical business. What if Facebook’s own growth rate slows from 60% to a still strong 30%, as happened at Google? From a level of 16x sales, Facebook’s stock would certainly fall by 20%, 40% or more, depending on the severity of the slowdown.